Among their many advantages – intraday liquidity, transparency, ease of use – exchange traded funds (ETFs) are highly touted for the benefits they offer via tax efficiency.

To be clear, when investors talk about tax efficiency, they are talking about how well an investment protects them from paying taxes while they own it.

It happens from time to time: mutual funds and ETFs can generate taxable income that most often takes the form of capital gains or dividends.

Matt Krantz for USA Today gives us two examples:

  • If an ETF owns a stock that pays a dividend, that dividend is passed on to the ETF’s shareholders. The investor may then owe taxes on the dividend.
  • If a stock has to be sold within a fund, this can generate a taxable event and the shareholder may have to pay capital gains. This is a far more frequent occurrence in mutual funds, since they have to sell shares raise cash in order to meet redemptions. [What can tax-loss harvesting do for you?]

ETFs try to avoid these taxable events. Dividends are tough to avoid unless the ETF  steers clear of stocks that pay dividends, which isn’t desirable. Even the broad S&P 500 pays about a 2% annual dividend. It’s all part of investing. [What you should know about capital gains and ETFs.]

A fund’s management makes a big difference when it comes to capital gains. If you’d like to avoid them, consider ETFs and look for ones with low turnover. You can research ETFs by looking around our site or visiting the provider’s website.

For more information about taxes, visit our taxes category.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.